Cost Swaps And Risk: An Analysis Of The Effect Of Cost Swaps On Degree Of Operating Leverage And Break-Even Points

Abstract

Financial institutions have, for a long time, used interest rate swaps to address risk in managing assets and liabilities. Variable interest streams can be “swapped” for fixed payment streams (or visa versa) to either increase or decrease the sensitivity of the financial institution’s profits to changes in interest rates. With the advent of outsourcing, all businesses have the ability to do essentially the same thing by swapping fixed or variable cost streams. This article addresses managerial accounting topics of break-even analysis and degree of operating leverage which both have implications on risk and cost of capital. The analysis demonstrates a point that is generally ignored in the treatment of these issues. Conventional understanding says that shifting costs from variable to fixed will increase both the break-even point and degree of operating leverage. The analysis demonstrates that this is not necessarily true and could, indeed, have the opposite effect. The analysis also provides the conditions for determining how a shift in cost will impact break-even points and degree of operating leverage. The analysis is timely and offers insights to managers as to how outsourcing can be used to address the management of risk.